Discounted Cash Flow (DCF) Interview Questions & Answers

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Finding another job can be so cumbersome that it can turn into a job itself. Prepare well for the job interviews to get your dream job. Here's our recommendation on the important things to You need to prepare for the job interview to achieve your career goals in an easy way. Discounted Cash Flow (dcf) is a valuation method used to estimate the attractiveness of an investment opportunity. The formula is the sum of the cash flow in each period divided by one plus the discount rate raised to the power of the period. Strong determination is required to crack the job. Follow our Wisdomjobs page for Discounted Cash Flow (dcf) job interview questions and answers page to get through your job interview successfully in first attempt.

"A DCF values a company based on the Present Value of its Cash Flows and the Present Value of its Terminal Value.

First, you project out a company's financials using assumptions for revenue growth, expenses and Working Capital; then you get down to Free Cash Flow for each year, which you then sum up and discount to a Net Present Value, based on your discount rate - usually the Weighted Average Cost of Capital.

Once you have the present value of the Cash Flows, you determine the company's Terminal Value, using either the Multiples Method or the Gordon Growth Method, and then also discount that back to its Net Present Value using WACC.

Finally, you add the two together to determine the company's Enterprise Value."

Subtract COGS and Operating Expenses to get to Operating Income (EBIT). Then, multiply by (1 - Tax Rate), add back Depreciation and other non-cash charges, and subtract Capital Expenditures and the change in Working Capital.

Note: This gets you to Unlevered Free Cash Flow since you went off EBIT rather than EBT. You might want to confirm that this is what the interviewer is asking for.

Take Cash Flow From Operations and subtract CapEx - that gets you to Levered Cash Flow. To get to Unlevered Cash Flow, you then need to add back the tax-adjusted Interest Expense and subtract the tax-adjusted Interest Income.

In all cases, the percentages refer to how much of the company's capital structure is taken up by each component.

For Cost of Equity, you can use the Capital Asset Pricing Model (CAPM - see the next question) and for the others you usually look at comparable companies/debt issuances and the interest rates and yields issued by similar companies to get estimates.

The risk-free rate represents how much a 10-year or 20-year US Treasury should yield; Beta is calculated based on the "riskiness" of Comparable Companies and the Equity Risk Premium is the % by which stocks are expected to out-perform "risk-less" assets.Normally you pull the Equity Risk Premium from a publication called Ibbotson's.

Note: This formula does not tell the whole story. Depending on the bank and how precise you want to be, you could also add in a "size premium" and "industry premium" to account for how much a company is expected to out-perform its peers is according to its market cap or industry.

Small company stocks are expected to out-perform large company stocks and certain industries are expected to out-perform others, and these premiums reflect these expectations.

You look up the Beta for each Comparable Company (usually on Bloomberg), un-lever each one, take the median of the set and then lever it based on your company's capital structure. Then you use this Levered Beta in the Cost of Equity calculation.

Again, keep in mind our "apples-to-apples" theme. When you look up the Betas on Bloomberg (or from whatever source you're using) they will be levered to reflect the debt already assumed by each company.

But each company's capital structure is different and we want to look at how "risky" a company is regardless of what % debt or equity it has.

To get that, we need to un-lever Beta each time.

But at the end of the calculation, we need to re-lever it because we want the Beta used in the Cost of Equity calculation to reflect the true risk of our company, taking into account its capital structure this time.

Levered Free Cash Flow gives you Equity Value rather than Enterprise Value, since the cash flow is only available to equity investors (debt investors have already been "paid" with the interest payments).

You can either apply an exit multiple to the company's Year 5 EBITDA, EBIT or Free Cash Flow (Multiples Method) or you can use the Gordon Growth method to estimate its value based on its growth rate into perpetuity.

In banking, you almost always use the Multiples Method to calculate Terminal Value in a DCF. It's much easier to get appropriate data for exit multiples since they are based on Comparable Companies - picking a long-term growth rate, by contrast, is always a shot in the dark.

However, you might use Gordon Growth if you have no good Comparable Companies or if you have reason to believe that multiples will change significantly in the industry several years down the road. For example, if an industry is very cyclical you might be better off using long-term growth rates rather than exit multiples.

It's hard to generalize because both are highly dependent on the assumptions you make. In general, the Multiples Method will be more variable than the Gordon Growth method because exit multiples tend to span a wider range than possible long-term growth rates.

The median multiples may change greatly in the next 5-10 years so it may no longer be accurate by the end of the period you're looking at. This is why you normally look at a wide range of multiples and do a sensitivity to see how the valuation changes over that range.

This method is particularly problematic with cyclical industries (e.g. semiconductors).

More debt means that the company is more risky, so the company's Levered Beta will be higher - all else being equal, additional debt would raise the Cost of Equity, and less debt would lower the Cost of Equity.

This is less common than the "standard" formula but sometimes you use it for companies where dividends are more important or when you lack proper information on Beta and the other variables that go into calculating Cost of Equity with CAPM.

Interest on debt is tax-deductible (hence the (1 - Tax Rate) multiplication in the WACC formula).

Debt is senior to equity in a company's capital structure - debt holders would be paid first in a liquidation or bankruptcy.

Intuitively, interest rates on debt are usually lower than the Cost of Equity numbers you see (usually over 10%). As a result, the Cost of Debt portion of WACC will contribute less to the total figure than the Cost of Equity portion will.

However, the above is true only to a certain point. Once a company's debt goes up high enough, the interest rate will rise dramatically to reflect the additional risk and so the Cost of Debt would start to increase - if it gets high enough, it might become higher than Cost of Equity and additional debt would increase WACC.It's a "U-shape" curve where debt decreases WACC to a point, then starts increasing it.

This is problematic because private companies don't have market caps or Betas. In this case you would most likely just estimate WACC based on work done by auditors or valuation specialists, or based on what WACC for comparable public companies is.

You can modify management's projections downward to make them more conservative.

You can show a sensitivity table based on different growth rates and margins and show the values assuming managements' projections and assuming a more conservative set of In reality, you'd probably do all of these if you had unrealistic projections.

Banks use debt differently than other companies and do not re-invest it in the business -they use it to create products instead. Also, interest is a critical part of banks' business models and working capital takes up a huge part of their Balance Sheets - so a DCF for a financial institution would not make much sense. For financial institutions, it's more common to use a dividend discount model for valuation purposes.